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2015: Chinese Banks’ Year of Living Dangerously

Workers cleaning windows of a building are seen behind China’s national flag at a commercial district in Beijing in this April 20, 2015 file photo.

Reuters

When China’s banks were listed and recapitalized more than a decade ago, they were supposed to be the vanguard of the country’s economic modernization. Instead, they are becoming the face of China’s potentially-lengthy stagnation as they stumble through the toughest hangover in their existence as modern commercial lenders.

1. Bad Loans Threaten Buffers.

As growth at China’s largest banks falls to its slowest pace since 2002, two sets of data illustrate why their hangover isn’t going to go away soon. Bad debt across the banking system is building up, but what’s more worrying is the way banks are provisioning against them.

Provisioning coverage, which measures a bank’s ability to absorb potential losses from bad loans, has been falling across bank categories even as sour loans rise. Beijing requires banks to keep the ratio at a minimum of 150%; banks are still well above that threshold, but the numbers imply that the system’s defenses are not keeping pace with the growth of these problems.

2. Capital Adequacy Under Pressure.

Another worrying indicator is capital adequacy, a crisis-prevention regulatory measurement that flags how much equity a bank must hold as a percentage of risk-weighted assets. Capital adequacy at large banks has fallen since a year ago, though it’s higher than at the start of 2014. China’s smallest banks, however, now have less capital adequacy than they did two years ago.

Over the last year, bad loans have climbed the fastest among state-owned banks, which include some of the nation’s largest. But it’s the smallest rural banks that bear the largest soured credit as a percentage of their loan books.

“Those are the things that we can see, but it may be the things that we cannot see that will make the situation more dangerous,” said Z-Ben Advisors analyst Ivan Shi. Capital adequacy is still stronger on paper than regulatory requirements, but that says nothing about the reliability of China’s bad-loan data.

3.Corporate Debt Surges.

The summer’s stock-market turmoil shook China’s vast shadow banking sector, but it didn’t really cut back China’s debt addiction. As some sectors of margin finance and umbrella trusts drew back, credit surged into other areas of the financial system. Analysts flag a rising bubble in corporate bonds, which in the first 11 months of this year reached 5.2 trillion yuan ($812 billion), up 39% from a year earlier to their highest level on record.

The fastest-growing has been a category called corporate bonds – a class of debt open to almost all companies of any size or shareholding structure – which has grown at a pace that dwarfs all other types of bonds, according to data provider Wind Information. This year has already produced a record number of defaults from Chinese corporations. Expect more next year, analysts say.

4. Weakening Asset Profiles.

China’s indebtedness is rising at a time when it should be deleveraging out of the nationwide credit binge that began six years ago. Measured against the country’s total economic output, the debt owed by China’s non-financial sector – the manufacturers and service providers that economists collectively call the “real economy” – has been increasing every quarter since mid-2011, according to data from the Bank of International Settlements.

It’s now among the highest in the world, bigger as a percentage of GDP than the U.S. and other developed economies. Deleveraging hasn’t taken off; China’s overall systemic leverage is likely to expand next year, Moody’s Investors Service said.

5. Not Just The Slowdown.

Beijing’s moves to wind down its control of interest rates cut into net interest margins, which measure how much banks can make from the differential between lending and borrowing. As the central bank freed the deposit ceiling this year, larger Chinese banks will soon need to offer higher deposit rates to keep up with smaller competitors.

Compared with book values, Chinese bank share prices have been persistently cheap, but analysts say this doesn’t necessarily make them good bargains.

It’s made it difficult for other banks to price new shares on capital markets substantially above their book value. The low prices underline the theme of Chinese banking in a time of transition: Buyer beware.